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Market Commentary: 1Q 2018

Welcome back! Volatility returned to the financial markets this quarter. U.S. and overseas stocks surged in January, corrected sharply in early February and then rebounded into mid-March. They dipped again into quarter-end, buffeted by a potential trade war and a Facebook data scandal. But despite the volatility, they ended down only 0.7% and 1.5% respectively. Emerging-market stocks held true to their higher-volatility reputation. They shot up 11% to start the year, fell 12% during the mid-quarter correction but finished the quarter with a positive 1.4% return. Unfortunately, core bonds didn’t play their typical “safe-haven” role in the first quarter, since Treasury yields rose across the maturity curve. True to form, core bonds also posted a 1.5% loss.

Here are the broad index returns through the First Quarter of 2018*:

U.S. Large Cap Stocks

-0.7%

Emerging Market Stocks

1.4%

U.S. Small Cap Stocks

-0.1%

Commodities

2.2%

U.S. Real Estate

-5.9%

U.S. Aggregate Bonds

-1.5%

Overseas Stocks

-1.5%

International Bonds

-2.0%

Economic Outlook

There are two primary observations about the quarter’s rocky ride. First, the recent 400-day long S&P 500 rally, that occurred without a single 3% decline from its high, was not normal. It was the longest streak in 90 years of stock market history. Comparatively, stock market declines of 10% or more are normal and have occurred in over half of all calendar years since 1950. The market has simply returned to “normal.” Second, despite the dramatic news headlines and market volatility, the economic news that contributed to the recent selloff was that the economy might be getting a bit too strong and the tight labor market could finally translate into higher wage growth and broader inflationary pressures. Fundamentally, the U.S. and global economies still look solid. Global growth may no longer be accelerating, but it remains at above-trend levels and the likelihood of a recession over the next year or so still appears low.

Be prepared for another bear market. The Trump tax cuts and new fiscal spending bill will likely stimulate more spending, deficit-financed measures that are likely to be inflationary. As a result, monetary policy and overall financial conditions will gradually tighten to compensate for the rising inflation. Consistent with the historical pattern, economic activity and asset prices will probably decline and the U.S. economy will slide into a recession and a full-blown bear market, a 20%-plus decline in stock prices. We are not there yet, but it is coming.

What is the best defense? First, it is worth remembering that a five-year or longer time horizon is the basis for any reasonable expected-returns analysis. It is over those longer-term periods that valuation (i.e., what you pay for an investment relative to its future cash flows) is the most reliable predictor of returns. Over the shorter term, markets and economies are reliably unpredictable and are driven by innumerable and often random factors (i.e., noise). Because of this, in the investing world, we are often our own worst enemies. We tend to fall prey to short-term performance-chasing, our natural inclination to “do something,” emotional responses and other behaviors that hurt us as investors. The best defense is having a sound, fundamentally-grounded investment process (like ours) that will work for the long term and sticking with that process through periods of volatility. Second, this may be the appropriate time to consider your capacity (and patience) for a protracted bear market and larger stock declines. It is easy to forget the experience of negative returns during periods of extraordinary growth. Now may be a good time to reconsider your tolerance for volatility (risk) and manage within your boundaries. Of course, we are happy to help.